All Banks Are Insolvent if You Believe They Are

by: Eric Falkenstein

A major difference between banks, and nonbanks, is the inherent susceptibility towards runs. No bank can withstand a run, which is a major reason why we have Central Banks to act as Lenders of Last resort. The key is simply that a bank is a way to intermediate between savers and investors. Most investments take a year, or 5 years, to generate any return. If you sell them before completed, you will usually sell them at a loss irrespective of their worth. Most savers want the ability to retrieve all of their money instantly, in case they need to pay for some emergency.

The solution to this problem, is to rely on the statistics that imply most people will not want all their money right away at the same time. Indeed, with deposit insurance, there are few consumer runs on banks as happened in the 1930s and before. But most banks and large complex financial institutions have lots of short term debt that rolls over, and if a sufficient number of investors do not roll over their debt, the bank either has to issue long term debt, or liquidate their assets. In times like 2008, both scenarios were inconsistent with viability.

Thus, a problem today is that we have no idea what the assets of a bank are really worth, because the information provided by banks does not allow someone outside to know the proportion of mortgages they hold with Fico scores<600, LTV's>100%, vintage less than 5 years, etc. Without this necessary information people make extrapolations based on what they know, such as where various types of debt trades. But to say the traded debt is a decent proxy for all their assets is absurd, and unfortunately that's how assets are being treated.

In the past week, prominent internet economists Tyler Cowen and Paul Krugman suggested that banks are insolvent, meaning, the value of their assets is below the value of their liabilities. They offered no data to support this assertion, I presume they merely inferred it via the stock market. Unfortunately, they are definitely correct if investors refuse to roll over short term debt, many large banks are insolvent, but this is just a self-fulfilling prophesy true at any time in banking.

It's a difficult problem, especially because simultaneous to financial stabilization plans, we have vague stress tests that could indiscriminately wipe out banks, as any official proclamation a bank is insolvent implies, through the dynamics above, they are insolvent. We also have various home owner bills that could drastically reduce mortgage values, such as changing the bankruptcy laws so that not only are these loans non-recourse, but the banks effectively do not have a first claim on the collateral as previously assumed. Further, such legislation could encourage a second wave of mortgage defaults as people try to qualify for the government's booty.

The markets are in such a funk that market valued accounting, applying market valuation estimates based on proxies, probably does imply a lot of insolvency. Yet non-mortgage loss rates are not outside the norm of past recessions and thus far are containable. The proxy approach using market values would unnecessarily destroy a great amount of franchise value so needed at this point in time. I get the feeling I'm reliving the US history from 1931-33, where the government turned a major recession into a Depression by misunderstanding the importance of providing liquidity and other ham-fisted efforts to fix things (Smoot-Hawley tariffs). Merely heeding M2 will not be sufficient to save us. Bernanke understands the importance of banks in recessions, as he thought Friedman was right to blame the Federal Reserve for its role in the Great Depression, stating on Nov. 8, 2002:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

He needs to also remember that one characteristic of recessions is that they are all different.